Five Pillars of Financial Freedom: Free Money & Retirement Plans

Why, hello. Welcome. If you are just joining into the community here at EGS, please check out the first few posts in this series entitled, Five Pillars of Financial Freedom. Pillar One was focused on avoiding bad debt. Pillar Two was broken down into a three-part mini-series and focused on the value of owning your own home. We are on Pillar Three today. Pillar Three is all about motivating you to put money into your 401(k) style retirement plan at work.

When I wrote the title for this blog, I was envisioning a beer guy at Fenway Park walking up and down the stadium stairs on a sunny afternoon in August yelling, in that thick Boston accent, “Freeeee money here, get your free moneeyyyy here!” Wouldn’t that be nice. I mean a cold beer for $10.00 on a hot day is great, but if I have the option, I’ll take the $20 and you can keep the overpriced beverage Mr. Beer Guy. But seriously – what if there is a way to get free money? Would you take it? It turns out there is a way to get free money, and odds are, you wouldn’t take it! Read on and find out how to reach into that beer guy’s cooler and pull out a half a million dollars of free money.

There are a variety of employer sponsored retirement plans. There are far too many plans to cover each one in detail in this post, so I am going up 30,000 feet and looking down from drone-level…. ehhh drones – sore subject. Anyways, most retirement plans are either defined benefit plans or defined contribution plans. A defined benefit plan is what your parents might have referred to as a pension. Defined benefit plans are becoming less and less popular, especially in the private sector. For that reason, I am going to focus on defined contribution plans, which would include the 401(k) and 403(b).

Defined contribution plans permit an employee to defer money into an investment account without paying income tax on the money. With a typical 401(k), an employer is required to contribute money into the plan for the benefit of the employee. To qualify for certain tax benefits, the employer must contribute at least 3% of the employee’s pay into the 401(k) for the benefit of the employee. Many employers have what is commonly referred to as a matching plan. A matching plan requires the employer to match the employee’s contribution. Usually, the match is 100% of the first 3% of the employee’s pay. Some generous employer’s will match up to 6% of an employee’s contribution.

For example, if you earn $50,000 and participate in a matching style 401(k) where the employer matches 100% of your first 3% and 50% of the next 3% (a max employer contribution of 4.5% of your pay), then you’d be in for some nice benefits. If you deferred $0 into the plan, you would receive $0 from your employer. If you deferred $1,200 per year (i.e. $100 per month), you would be deferring 2.4% of your pay into the plan so your employer would match 100% of that ($1,200) because it is less than 3% of your pay. Not bad, right? That is a 2.4% increase in your annual pay just for filling out some forms.

However, if you want to reach into the beer guy’s cooler and pull out $2,250 of free money, here’s how. Defer 6% of your pay into the plan. 6% is $3,000 per year or $250 per month. Now don’t think of this as lost money – it is deferred. You are deferring income from the current you to the future you. Because you deferred 6%, your employer is going contribute 3% ($1,500) plus an additional 1.5% (remember 100% of the first 3% plus 50% of the next 3%). This additional 1.5% is equal to $750, which leaves you $2,250 wealthier. This is free money because you didn’t have to do any additional work to receive it.

Why am I writing about this? Because most people want more money. People look for jobs that pay more, search how to start a side hustle, and how to work from home and make six figures. Apparently, no one told them that their employer might just be giving money away for free on Tuesday in the lunch room.

In a recent article, Bloomberg cited a study which found that 79% of Americans work at a place that sponsors a 401(k) style plan. However, only 41% of the 79% are making contributions to the plan. This means that only 32% of Americans are making contributions. That is crazy! If you have a 401(k) style plan available to you, especially a matching style plan, you can’t afford not to get that employer match. I’m talking about getting you a 3% to 4.5% raise just by filling out a few forms and foregoing 3% to 6% of your pay. You have to be in the lunch room on Tuesday people!

You may be tempted to say you can’t afford to lose $250 per month. I will leave open the possibility that there are people who despite their best efforts to cut costs are unable to put any portion of their pay into their retirement plan. Having said that, in his book, Rich Dad Poor Dad: What the Rich Teach Their Kids About Money That the Poor and Middle Class Do Not!, the great Robert Kiyosaki says you should always pay yourself first. Also, keep in mind that retirement benefits are often protected from creditors depending upon the particular type of plan/account and applicable state law. With that principle in mind of paying yourself first, let’s look at the effect of paying yourself first.

If you deferred the minimum 3% of your pay to get the employer match each year and increased that amount by 2% per year (due to pay raises) you would start out receiving $1,500 of free money in Year 1 (see above for math on that). If your pay increased 2% each year, you’d be making $51,000 now instead of $50,000. If you then deferred 3% of that $51,000, your employer would contribute $1,530 in Year 2, which is effectively a 2% increase on the $1,500 you received for free in Year 1. The following chart illustrates how much free money you would have at age 65 assuming 10% annual growth, 2% increase in pay annually, with the variables being your starting age and the employer contribution (3% or 4.5%).

Starting Age

Free Money at 65 on 3% Employer Contribution

Free Money at 65 on 4.5% Employer Contribution

25

$ 847,571.00

$ 1,271,356.00

30

$ 513,894.00

$ 770,841.00

35

$ 307,874.00

$ 461,811.00

40

$ 181,009.00

$ 271,513.00

45

$ 103,193.00

$ 154,790.00

50

$ 55,743.00

$ 83,614.00

As I write this, I am literally in shock. I keep checking the numbers. The question is, “how can you afford not to take this free money?” Seriously. We are talking the difference between $0 at retirement (68% of Americans) and over a million dollars of FREE MONEYYYY!!!!This is not the money you contributed. This is solely the money your employer contributed.

This chart illustrates the power of starting early, but it also illustrates that it’s never too late to start. Even at age 50, if you defer 3% each year of your pay, increase your deferrals by 2% per year, and earn 10% compounded over 15 years, then you are literally leaving over $50,000 in the beer cooler by not putting money into your retirement plan. Take notice of the huge difference between the employee who only defers 3% and the employee who defers 6%. The difference is tens of thousand if not hundreds of thousands of dollars just for going that extra mile. Just do it! Victory!

If your employer does not currently offer an employer sponsored plan, you should consider asking them about setting one up. Alternatively, tune into the next post in this series because Pillar Four is focused on individual retirement accounts (IRAs). I got my start saving for retirement using an IRA.